Author: Karl Whelan

Promissory Notes: The Movie

The text below is a secret draft of the opening scene of an upcoming Hollywood movie. The movie opens at some date in the near future with a conversation between a finance minister, let’s call him Baldini, and a European bureaucrat of Scandanavian origin, let’s call him Wally. (Any resemblance between the characters below and real individuals is purely intentional.)

Wally: Greetings Mr. Minister.

Baldini: Ahh, tis yourself Wally.

Wally: Mr. Minister, I bring a proposal from your European partners.

Baldini: Pray tell, Waldo, what’s the deal?

Wally: Well, as you know, our Greek sovereign debt restructuring has gone fantastically. Combined with the sale of Macedonia to the Former Yugoslav Republic of Macedonia, we’ve practically solved all our problems there. So we’re thinking it’s your turn. We’re proposing that you lengthen maturities on your debt and cut back on some of the principal to reduce your debt burden by over €30 billion. And, to be honest, you’re not getting another red cent from us unless you agree.

Baldini: Is that so? Well you know what Waldo, we’ve got a different plan, one that also reduces our debt by €30 billion but doesn’t involve defaulting on our sovereign bonds.

Wally: Really Minister, this isn’t a time for gallows humour.

Baldini: Indeed, there’s nothing funny about it. No, I’ve been talking with the brains trust here at the Ministry and they’ve explained to me that apparently we’re going to be writing a cheque every year for €3.1 billion until two twenty three and then a bit more after that. Now I’ve been trying to get my head around this business, but I’m just a simple fella, and I can’t figure out for the life of me what we’re getting in return for this money. So, I’ve decided to cancel it. I hear your Eurostat boffins have been counting all of these payments as part of our national debt, so we’ll give them a call in the morning to let them know they can forget about that.

Wally: Really Mr. Minister, this isn’t a time for jokes. I’m sure you’re well aware that the, ahem, promissory note payments are the main asset of a certain Anglo Irish Bank and, its terrible twin, the Bank of Fingers. And I’m sure you’re also aware our beloved ECB is owed a fortune by those two institutions. You can’t really expect to endanger the ECB in this fashion.

Baldini: Hold your horses Wally! Sure aren’t the ECB’s loans to these banks fully collateralised, over-collateralised in fact. Sure I’ve met those ECB eggheads many’s the time and there’s no flies on them lads. I’m sure that’s lovely collateral they have, so no need to worry.

Wally: But, Mr. Minister, don’t you know that the promissory notes have been used as collateral for the loans from the Irish Central Bank to Anglo and the Bank of Fingers?

Baldini: Is that so? Ah well, sure that’s Paddy Honohan’s problem.

Wally: Ah now Mr. Minister, come off it. You know well that without the promissory notes, these banks can’t pay back the emergency liquidity loans they got from the Irish Central Bank and your predecessor has guaranteed that state funds would be used to pay these loans back if necessary.

Baldini: Really? Ye think? I’ve wondered about that. Wouldn’t you imagine there was a major debate in the Dail about that guarantee? But you know what, I couldn’t find anything in the records. And we’ve had the lads here in Merrion Street scouring the place for that guarantee and still nothing’s come up. Sure ye can’t find anything anymore since we introduced that new PPARS2 IT system … No, I’m afraid me mind’s made up. No more promissory thingybobs anymore.

Wally: But this will mean that Anglo and INBS’s debts will have been monetised!

Baldini: I dunno Wally, you’re a quare fella. What’s monetised mean?

Wally: I’m going to have to talk to Mr. Drago about this. I suspect he won’t want to keep lending all that money to your other banks.

Baldini: Well sure we’ll see about that won’t we?

[Baldini raises one eyebrow at the camera. Fade to black].

The question is what happens next?

Suggestions for the casting of Baldini and Wally are welcome. Leonardo di Caprio has expressed an interest in playing the minor but crucial role of Lorenzo Beeni Silly.

Who Owns Senior Irish Bank Bonds?

I’d like to pass on a few comments on the question of who owns senior Irish bank bonds, an issue that has been discussed on a number of occasions by Seamus Coffey from UCC.

Here’s a nice chart from Seamus’s blog using data from Table 4.2 of the Central Bank’s Money and Banking statistics. The chart shows that when the September 2008 guarantee was put in place, only €23 billion of the €97 billion in outstanding bonds of the covered banks were classified by the Central Bank as being held by Irish residents while today that share is €50.7 billion out of €77.6 billion.

There are a number of reasons why one should be careful in interpreting these statistics.

First, as I understand it, the Central Bank don’t keep track of secondary market activity in these bonds and so don’t actually know who the current owners of these bonds are. The estimates are largely based on the first holder of the debt when it is issued.

Second, in some cases, the “holder” is a trustee that manages the debt issuance and the subsequent payment streams on behalf of the issuing bank. So, for example, if an Irish bank issues debt that is held by an Irish resident firm Custodian Plc who manage the payment streams, but the ultimate beneficial owner of the debt (who ultimately gets the coupon payments, etc.) is a German pension fund, then the Central Bank statistics will report the debt securities as being held by Irish residents.

Third, much of the €50.7 billion currently deemed to be held by Irish residents is stuff like “own-use” bonds guaranteed by the Irish government. If, however, one is debating the question of failing to pay out on unguaranteed bonds, then you are generally talking about bonds issued prior to September 2008 and these are largely classified in these statistics as “foreign resident” bonds.

Finally, this may be obvious but it’s perhaps worth pointing out that the fact that some of these bonds may be owned by Irish residents is hardly a sufficient justification for using taxpayer funds to redeem them, rather than letting the pension funds or private citizens lose money on a bad investment.

To be honest, the fate of senior Irish bank bonds is probably generating more heat at this point than it should. It seems to me that there is no chance of the government adopting a policy of failing to pay out on AIB or Bank of Ireland’s senior bonds, so what is genuinely at debate is the roughly €4 billion or so in senior bonds outstanding at Anglo and Irish Nationwide. For what it’s worth, I suspect that most of these bonds are currently owned by international hedge funds and distressed debt desks of investment banks. So far, their investment strategy has been working out really well.

In relation to the cost of the banking bailout, an issue that may loom larger in the future than senior bonds is the policy the Irish government should adopt in a potential sovereign default situation to future payments on the Anglo and INBS promissory notes, keeping in mind that their major creditor is a certain Frankfurt-based institution.

Government Revenues and Spending

One of the problems that plaugues discussion of the Irish public finances is there is a fairly widespread confusion over how much the government takes in as revenues and how much it spends.

Many people know that the figure for “tax revenues” has been about €30 billion in recent years, via press coverage of the monthly exchequer returns. (See here for the 2010 end of year exchequer returns showing €31.7 billion in tax revenue.) Many people also know that we have run deficits of close to €20 billion in recent years.

Together, these two facts have lead to the wide repetition of statements along the lines of “we are taking in €30 billion and spending €50 billion.” Often, a particular item of government expenditure, such as public sector pay or social welfare is then compared to the revenue take of €30 billion to illustrate the huge fraction of government revenues that it takes up.

It turns out however that a more accurate description of the Irish public finances has been the government has been taking in about €50 billion and spending about €70 billion. This pattern is hard to assess from looking at the Exchequer statements because, for example, they do not count the €11.4 billion in “social contributions” such as PRSI as taxes. Indeed, the whole definition of tax revenues is a bit arbitrary. I believe the USC is being counted as tax revenues, while various levies that it replaces were not.

The most useful description of the state of the Irish public finances is the materials provided to the European Commission, for example in Friday’s Stability Programme Update. Go to the second last page and you’ll see a useful breakdown of exactly how the General Government Deficit of €49.9 billon was determined. Take away the promissory note worth €30.8 billion and this deficit would have been €19.1 billion, determined by spending of €72.4 billion and revenues of €53.3 billion. (The last page contains a description of the relationship between the Exchequer Balance and the General Government Balance.)

Unfortunately, this simple and clear presentation of the public finances is not emphasised in the materials regularly released by the Department of Finance. Perhaps one of the reforms that the two new minsters in charge of spending and taxation could agree to would be to release regular clear presentations of the tax and spending figures underlying the general government deficit.

AIB Subordinated Liabilities Order

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?

Stephen Collins and Groupthink

Writing in today’s Irish Times, Stephen Collins takes the following from the Nyberg report:

It is probably no accident that some of the cheerleaders of the boom have now turned into leading prophets of doom. The same reckless, gambling instinct that fuelled admiration for Seán Fitzpatrick also underpins the “burn the bondholders and damn the consequences” philosophy.

If there is one lesson from Nyberg it is the need for prudent economic management in the years ahead, with careful weight being given to the views of the European Commission and our EU partners.

I think it’s worth echoing Kevin O’Rourke’s previous warning about Mr. Collins and his history lessons. Mr. Collins thinks the lesson we should learn from the crisis is “Don’t be reckless. Be prudent.” However, this isn’t a very useful lesson. I’m sure that Bertie Ahern, Charlie McCreevy and Brian Cowen all believed that their policies were prudent. They were running budget surpluses and their “prudential regulator” told them they had some of the best capitalised banks in the world.

For me, the real message of Nyberg’s report is that Ireland’s economic and political establishment exhibited an extreme form of groupthink during the housing boom. Nyberg’s report brings up groupthink time and again. He describes the phenomenon as follows

Groupthink occurs when people adapt to the beliefs and views of others without real intellectual conviction. A consensus forms without serious consideration of consequences or alternatives, often under overt or imaginary social pressure.

And the report is very clear about the role played by groupthink. For example

The generally held belief in a soft landing outcome, which was quite common even as late as 2008, can also be seen as a consequence of groupthink.

Now let’s take a step back from current economic events and try to ask whether there has been a groupthink element to policy making in the period since the bubble burst. Mr. Collins lashes out at those who wish to “burn the bondholders”. However, these people have had no influence whatsoever on the conduct of economic policy.

Instead, economic policy of recent years has been dictated by the idea that, however difficult things may seem, our situation is “manageable” and that all Irish bank and sovereign debt can and must be paid back.

Those who espouse this vision, including many with weekly opinion columns, backed the September 2008 bank guarantee and also supported whatever incremental measures the government produced as “the final solution” to our banking problems, for example via their backing for the NAMA plan. They have also regularly warned us not to “scare the horses” by suggesting debt burdens might not be manageable.

If anything, it has been this viewpoint, backed by Mr. Collins and many others, that has become the new groupthink. It is not at all impossible to imagine a future Nyberg-style report into the reasons for an Irish sovereign default focusing on the “manageability doctrine” as perhaps the key reason why Ireland failed to avoid default.

What we need now is more respect for dissenting voices, not weekly smackdowns of those who dare to disagree with the prevailing orthodoxy about what constitutes prudent economic management.