One item that hasn’t been discussed on this blog in recent weeks is the Subordinated Liabilities Order issued by Minister Noonan in relation to AIB’s debt instruments. I guess everyone knew this was coming so the order in itself was no big deal. However, the order is now getting some attention (here and here) due to the fact that it appears to mess with existing capital hierarchies. In particular, it appears to have left the preference shares owned by the Irish government untouched while adjusting the terms of subordinated debt.
This seems to me like a bad idea. I’m all in favour of seeing subordinated bondholders in AIB get wiped out given the enormous extent of state support that has been required to keep the bank going. But if you are going to do this, then you should respect the hierarchy of claims that exists.
Many of us have questioned the wisdom of the protection of senior bondholders in Irish banks at the expense of a potential sovereign default. However, those who have argued in favour of protection of senior bondholders have generally made points about the need to maintain the reputation of the domestic banking sector in light of its huge ongoing funding gap. If this is our approach, then is it wise to get a reputation as a country which randomly up-ends existing claims hierarchies at the whim of a Minister?
16 replies on “AIB Subordinated Liabilities Order”
No.
Karl
we’ve discussed this before (even before the CI(F)S Act in December) – the preference shares were never a ‘true’ investment, without their input AIB would clearly be (still is?) bankrupt/insolvent. Most bond traders (Davys apart) don’t seem to have a big issue with the government’s stance on this, the one’s i’ve spoken too are genuinely, if quietly, impressed with the government’s recents aggressiveness on this issue. The future of subordinated debt in banks is in some ways under question at the moment in even the good banks anyway, i wouldnt worry too much about burning them. Thats the key difference between the debate on sub vs senior debt burden-sharing.
@ Eoin
I wonder do international investors share the stance of the domestic non-Davy’s bond traders?
PS I think the remaining common equity is more of an issue than the preference – in time, as @Eoin alludes to, the government preference shares will come to be seen as bailout money.
@ Karl
honestly, i don’t think too many people care what happens to subbies. Senior is far, far, far more important (slippery slope arguments aside). Even the ECB doesnt really seem to care too much. As i said above, sub-debt will be a far less importnant part of the capital structure in the years ahead, IMO, so there’s far less collateral damage from burning them.
Question – do you think an Irish bank will be able to sell new sub debt before the year 2020, even if they treated the current crop nicely?
Surely not “the need to maintain the reputation of the domestic banking sector”; but rather, the need to restore from junk status the “reputation of the domestic banking sector”.
Eoin
“Question – do you think an Irish bank will be able to sell new sub debt before the year 2020, even if they treated the current crop nicely”
Nope. I think they are damaged beyond repair reputation wise. Carve the good out, rebrand, sell chunks, put the dross into a skip and deliver to Mr Trichet as a retirement present.
the issue KW and the FT have noted as others is that there is (like it or not) a hierarchy : equity -> subbies -> seniors -> deposits : in terms of “rational” risk sharing and standing-in-linedness. the typical ex-ante required return for these investments represents the relative risk.
What we now have in a mad bad and sad attempt to both keep some equity skin in the game and to leave no senior bondholder unbailedout is a legislative reordering. Mind, when we have Herr Stark suggesting that requiring investors to share risk as “populist” i think all of us who have ever taught or written on corporate finance need to check what dimension we are in.
The legislative shuffling of risk is akin to the sterling work of Illinois State Representative Edward Goodwin and his law on pi…
The law has been severely diminished over the alst number of years. Previously the US diminished international law. Then the the ECB and Commission diminished civil law in the face of disaser. Now Ireland is going to unilaterally alter civil law. This is a major mistake and dispays an unforgiveable ignorance of why honouring the law is important for a small country.
Eoin:
More than “a few subbies” is at stake here.
First, under Basel III, bank funding will consist principally of covered bonds and Cocos, which are sub-debt. In this context, governments taking liberties with the contractual terms of sub debt today is important to the future of the banking sector: it shows us that the terms sub debt aren’t worth the paper upon which they are written. European banks will have *at a minimum 120 bn of Cocos to sell in the next 3 years. Some doubt that they can sell them. With this precedent, they probably will not.
More importantly, by issuing the SLO, the Irish High Court exercises a new and surprising power given to it by the Bank Restructuring Bill — that to alter the terms of contracts ruled by laws other than Irish Law (English law, in this case). Everyone should worry: what stops the Irish from passing a bill tomorrow granting the Irish High Court the right to vary the terms of, say, Japanese earthquake insurance, or the payout of the German Lottery or — indeed, the US constitution? Of course, they would only do this when they could get (as in this case) their hands on some money as a result; but, are you saying, that if they will, they can?
Finally, it’s not “burden sharing”. Burden sharing means: Irish government puts capital (cash) into AIB and in return gets shares; and sub debt holders put capital (their bonds) into AIB and get shares. That would be an example of burden sharing. This is not burden sharing. This is expropriation.
The allegations of impropriety e.g. “expropriation” etc., by the holders of subordinated debt are overstated. The English Court of Appeal has already recognised in the context of Northern Rock that the private interests are not entitled to benefit from the fact that the State has intervened to save a bank. The courts recognise that without State intervention a bank with liquidity difficulties may fail, and are prepared to “value” the private rights of parties on the legal fiction that no State intervention in fact occurred. If anything, the justness of this approach is even stronger in the case of AIB than Northern Rock. The latter institution was arguably solvent, albeit with a severe liquidity problem. The case for saying AIB would be insolvent is far stronger. Against this background, it does not lie in the mouth of the holder of an instrument, e.g. sub debt, which is expressly stated to be subordinated to all other interests, to complain that it will not be paid back in full. The argument that the injection by the State, via the NPRF, of monies should be treated as simply an investment by a new shareholder is nonsense. These monies were put in to prop up the failing bank, and was done in the public interest.
The suggestion that the fact that the subordinated debt is stated to be governed by English law is a red herring. The Irish State is entitled to regulate banks licenced in its jurisdiction. Indeed, some on this site would argue that it has gone too far and should simply have let at least some of the banks fail. Be that as it may, to suggest that the Irish State, having pumped huge amounts of monies into AIB has no more interest in the matter than it would in apanese earthquake insurance, or the payout of the German Lottery is daft.
The bottom line is that had the State not intervened, there is no doubt but that subordinated bonds would have recovered nothing. It would be perverse, and affront to fairness, were the holders of such risk capital now to exploit the State’s intervention. This is especially so when it seems likely that much of this debt was purchased by specialists in distressed debt and is not still held by innocents.
In comunist countries after world war II, the State was paying to the owners 10 – 20% of their capital value. Some of them didn’t even receive any compensation. The Republic of Ireland have intention to confiscate part of property of AIB bondholders – subordinated bonds, through Irish High Court.
AIB shares are listed at the Irish stock exchange. AIB is not in default. They pay taxes, wages to employees, service the senior debts, pay coupons on preferencial shares, sell assets and realize income. The Republic of Ireland has chosen the victom. They intend to take away the assets: subordinated bonds. 80% by recommendation of Minister of Finance.
They made the legal framework with help of a Court…. In the name of taxpayers.
Like in the dark age or comunism.
Why only subordinated bondholders? Because they had higher interest and higher risk. The State has converted it’s own debt into shares for 0,34euro, but to subordinated bondholders they give haircut of 80%. Why not convert their debt for equity? Because, that would mean dilution of State interes. It’s easier to take away.
EU is silent – Like they were silent in year 1939 when Germany was taking away Judish assets.
How will this end? In a couple of years, AIB will be profitable. Shares will relly, Pension fond will earn double or triple and subordinated bondholders will claim their property in European and international courts….In the name of democracy.
With respect, it does not advance the bondholders’ case to make inappropriate analogies with 1939 Germany.
Subordinated debt is issued on the express understanding that it ranks behind other debt, and thus it is the next in line after shareholders’ equity in the event of insolvency. The fact that subordinated debt stands behind all other unsecured debt makes it easier to assess whether or not the holders of such debt were likely to recover anything in a hypothetical winding up. Unless there is sufficient in the “pot” to pay off all the other creditors in full, the holders of subordinated debt recover nothing.
Indeed, it is precisely because subordinated debt is exposed to risk that it is included as an element of a bank’s capital requirements. The thinking being that subordinated debt can provide an important market mechanism that leans against excessive risk taking. This should work as a counter-balance to the common shareholders’ incentives, which could lean towards excessive risk taking, as a result of the limited liability of shareholders. See Basel Committee on Banking Supervision in its Consultative Document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability (August, 2010).
The reality is that “but for” State intervention in AIB, the institution would have gone into liquidation and there would not have been enough in the “pot” to pay off all unsecured creditors in full. The holders of subordinated debt would have recovered nothing. The 2010 Act and the SLO simply recognise this reality and deprive the subordinated of the benefit of the State intervention. It is difficult to see how the subordinated debt holders can claim to have any legitimate grievance: they signed up for “risk” in a financial institution which became insolvent. They cannot realistically argue that they had a legitimate expectation that the State would intervene to prop up the bank.
Why do you say that there would not be enough money in the pot to pay sub bondholders if AIB had gone bust? I’m not so sure about that… And if that was really the case then why not simply letting the bank go bankrupt? If the Irish Government deliberately chose to avoid the bankruptcy scenario, making the bank viable by injecting more capital through a standard financial instrument (which are preferred shares), then it’s quite clear to me that they should continue to play by the rules and respect well accepted capital structure hierarchies. And if they don’t it will come at a high cost as Ireland, from then on, will most probably be regarded in the financial markets as a Banana Republic.
National Pension Reserve Fund had injected 5.6 billion into AIB as of 31 March, 2011. Some of this arose following the 22 December, 2010 court application. That application was heard in camera so we do not know the precise state-of-play in the bank.
gadge:
Your comparison with Northern Rock is wrong: first, Northern Rock was nationalised which AIB has not been; second, in the restructuring of terms of debt that followed, capital hierarchies were preserved (common stock was wiped out first, Lt2 was treated more gently than LT1, etc.) and all categories of debt in each class were treated in the same manner. In the case of AIB, the state preserves itself (and pays itself a dividend on its preferred stock — they just did on Friday) while arbitrarily expropriating higher-ranking bondholders. If a private shareholder did this, he’d be jailed. Are you saying the state can do whatever it wants because it is the state? Is there a presumption of infallibility — that whatever the state does must surely be in public interest and who are we to question it?
There is nothing red-herring about the argument that the Irish state has no powers to alter terms of contracts governed by English Law. It does not. Under certain conditions — were AIB allowed to fail, in a subsequent reoganization Irish courts could make such a decision; we never got to that point. All we get is arguments of the woulda shoulda coulda variety.
The argument that had not the state intervened subbies would have received nothing is neither here nor there: we do not know what would have happened. What we do know is what happaned that subbies of AIB have already agreed to a 50% haircut at the time of first AIB recapitalization. Unfortunately, that first recapitalization didn’t work and further losses must be absorbed. So, why are losses not taken by state owned preferred which rank lower than the sub debt? Why do all losses now have to be born by some members of the sub class and not others?
Finally, your reference to the type of person owning some of this debt really is a red-herring. First, some of it may be owned by hedgies, but much of it is owned by pensions of ordinary working people. And, second, since when does the Irish law distinguish between types of persons? Do hospitals in Dublin refuse to treat people with red hair?
I understand how you feel — some of the bank bail out money is probably yours, but none of your arguments work to justify the money grab. No European government during the current banking crisis has done what the Irish are doing — and for all the excellent reasons I have named.
Now, what is at stake is the status of all debt in Ireland: if the Irish state can do this to bank subbies what stops them from doing this to any other class of debt or property in Ireland? How about Irish sovereign bonds? Why should anyone be buying Irish sovereign bonds if the Irish can pass some SLO tomorrow and render it worthless?
Incidentally, have you seen this report:
http://www.irishtimes.com/newspaper/frontpage/2011/0514/1224296946151.html
?
The state asset stripping the banks it has bailed? This too would be considered criminal if a private shareholder ever attempted it.
Have a nice day.
incidentally: if you have any doubt about the effect the SLO is having on the market’s confidence for Irish sovereign bonds, look no further than IE00B4TV0D44 . on the day on which the 2010 resolution bill was passed, it was priced at 78 cents and yielded 8%; today, in the aftermath of the SLO, it is priced at 66 cents and yields 11.5%. irish government’s cavalier approach to debt instruments is having precisely the effect everyone would expect. keep going and we will eventually see 50. Ireland returning to the market in 2013? I dont think so.