IT Piece on Bad Banks and Risk Insurance

Here‘s me in today’s Irish Times arguing against the current bad bank and risk insurance proposals.

O’Toole and the Government on the Pension Levy

Tonight’s Questions and Answers featured a heated exchange between Fintan O’Toole and Martin Cullen about whether the government knew how the pension levy was going to work when it was introduced. O’Toole has framed this question as being about whether the levy was applied to gross income or to net income. In his original article about this, he had asked

Is the levy a percentage of a worker’s entire income, or of that income after tax and PRSI? The answer to this question is crucial.

The article went on to heavily criticise the Taoiseach for asserting that the levy was applied to gross income and argued that this is not the case, a criticism that was repeated on Q&A.

Let me attempt to cut through the Gordian knot here and explain why both O’Toole and the Taoiseach are sure they are correct.

Bacon, Bad Banks and Risk Insurance

Today’s Irish Times reports that the government has hired Peter Bacon

to assess the possibility of creating a “bad bank” or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending.

I know I’m at risk of sounding like a broken record on this topic but, given its importance, I’ll add my latest two cents on this. I’m not in favour of either this form of “bad bank” or a risk insurance scheme.

A Good Investment?

Writing in today’s Sunday Times about the government’s €7 billion re-capitalisation of AIB and BOI, Damien Kiberd says “The money invested will almost certainly be recovered and, in the interim, it will pay the state an annual interest rate of 8%.  This will bring the exchequer €560m a year”.   Later in the article, Kiberd points to this €560m as one of the key measures that will help to improve the public finances. This idea that the money is a sound investment of taxpayer money has also been raised in recent days by the Minister for Finance and by Brian Goggin, CEO of Bank of Ireland.  Despite this, I was a little surprised to see a high profile journalist endorse this position so strongly.

The scenario outlined by Kiberd is, of course, one possible outcome.  But one can think of others.  For instance, even if these banks remain in private ownership, they may not be able to pay back the government’s preference share investment in the five-year time frame envisaged and we can hardly be confident that a profit would be made from the options to convert the preference shares into ordinary shares at the strike prices agreed in the statement.  More worryingly, if the banks need further recapitalisation or  end up being nationalised, there would be little reason at that point to expect to see all of the original investment back.

In relation the “guaranteed 8% return”, there will doubtless be a transfer of €560m per year from these banks to the government.  However, to the extent that these transfers further diminish the banks’ equity capital, then any future government injections of capital could be seen as just giving this money straight back so that, on net, the taxpayer doesn’t really benefit from this interest.  And, of course, if the banks are nationalised, then these interest payments will just be transfers from one branch of the public sector to another.

Just to be clear, I am not saying that the rosy scenario can’t happen.  I don’t claim to know the full extent of bad loans at these banks, so I’m not putting forward a judgement here on the need for (or likely extent of) future capital injections.  Still, I’d be interested to know what our band of expert contributors and commentators think about the likely return on the  government’s recapitalisation investments.

Lenihan on Insurance and Bad Bank Proposals

Here are the latest comments from the Minister for Finance on the “bad bank” idea.  (And just to be clear, commenters, the bad bank proposal as currently understood in policy circles means governments overpaying for bad assets – a bad idea – and not the process of maximizing the sales value of these assets after banks have been nationalized – a good idea if nationalisation is indeed required.)

The headline “Lenihan says Government will consider setting up ‘bad bank’” confirms what anyone who watches RTE will already know (and what anyone who reads this blog will know I’m not very happy about).  However, the piece starts out promisingly.    “We can’t be jump-led by markets and market expectations into solutions that suit the banks rather than the people,” said Minister for finance Brian Lenihan last night, who noted banks were using the media to try to force politicians to adopt these types of state rescue plans.   Well said Minister!  Couldn’t have put it better myself.

And then some more good stuff: “Some of the proposals that have been advanced today such as risk insurance seem to involve a payment of a definite premium to the taxpayer in return for the assumption of an indefinite risk. And that is not something that any government could commit itself to,” said Mr Lenihan.   That’s the spirit!

But then things get a bit murky:  He said one of the difficulties with creating a scheme to deal with toxic assets was that it would add to the exposure of the state in relation to its sovereign debt. But he said it could be argued that if the Government had enough information on toxic assets – and Ireland was a small enough country to do this – and it could eliminate the risk then it would improve the risk posed by the existing Government bank guarantee scheme.  “We are at a great advantage that many of the larger (European) states have very extensive loan books and it is very difficult for them to do the type of comprehensive trawl through their banking system that we have been able to do,” said Mr Lenihan, who noted that a lot of the toxic assets held by European banks related to commercial paper, which was much harder to value than the property-based debts held by Irish banks.

This sounds a bit like grasping defeat from the jaws of victory, the minister bending over backwards to figure out why the current-vintage bad bank proposal — while generally a bad idea — might actually be a good idea here.  

I’m not exactly sure what the Minister is driving at here.  But I will point out that the most coherent argument put forward in comments yesterday in favour of bad banks rather than just re-capitalisation (from Mick Costigan) involved the Knightian uncertainty provoked by toxic assets.  Because people don’t know the distribution of losses, even a big re-capitalisation could still leave uncertainty about the potential for even bigger losses and thus doesn’t deliver confidence in the banking system. 

This is an interesting argument though I don’t think it’s relevant to the Irish case.   Firstly, there has to some figure for a large enough re-capitalisation (for instance, the full value of the bad assets) that gets rid of any Knightian uncertainty concerns.  Secondly, our toxic assets aren’t rocket science CDO-squareds built by physicists which can’t be valued because nobody understands them.  They’re bad loans to builders and we can go about making a reasonable guess at what they’re worth today.   Indeed, the minister seems to be making exactly this point.  So, as far as I can see, the Minister’s arguments seem to further point against the need for a bad bank scheme.