Author: Karl Whelan

Baltic Meltdown Avoided?

Just arrived in my inbox, a link to this IMF article, containing the following paragraph:

Meltdown avoided

It is too early to pass final judgment on the success of the Baltic strategy. Adjustment is still far from complete, and the current problems in the eurozone may yet complicate recovery. What is clear, however, is that the most dire predictions have not come true. Despite an unprecedented economic downturn―cumulatively, GDP has shrunk by about a quarter―devaluation and banking crises have been avoided.

So they’ve lost quarter of their GDP but a meltdown was avoided? I guess this shows that the definition of a meltdown is in the eye of the beholder.

Argued the Case for Default?

Someone called Maeve Sheehan has a piece in today’s Sunday Independent describing how I appear in Department of Finance Secretary General Kevin Cardiff’s diary as giving a seminar at the Department. I did give such a seminar, on September 17.

Ms. Sheehan describes me as follows “Professor Karl Whelan, another UCD economist, who has argued the case for default.”

I am genuinely unsure what Ms. Sheehan is referring to here. But I thought I’d use this forum to clarify that I have never advocated default on Irish sovereign debt. In addition, I have only ever discussed the idea of bank bonds being defaulted on in the context of legal provisions that allow for such defaults when a bank is insolvent or in the context of internationally-accepted special resolution regimes, which allow for an orderly approach to dealing with bank creditors when a bank is insolvent and which generally contain many protections for such creditors.

Also, because the above sentence could be radically misunderstood if one made the easy mistake of missing the word “has”, I would also like to clarify that at no point during my seminar at the Department of Finance on September 17 did I advocate default on either sovereign or bank bonds.

NAMA Does Not Borrow from the ECB

One of the really strange things about economics reporting in Ireland is that once a politician has said something with enough authority, it becomes repeated as truth time and again by our financial journalists, no matter how untrue. An incredible example of this is the idea that NAMA borrows money from the ECB.

During the long tedious NAMA debates of 2009, every government politician was sent out with a spin line about NAMA involving the government getting cheap money from the ECB. Even though it was untrue then, the idea has remained amazingly popular. Now, as rumours of some form of NAMA 2 (perhaps for mortgages) start to circulate, our financial journalists are still busy misrepresenting the basic transactions at the heart of the original NAMA.

Today’s Sunday Times (not on the web as far as I know and I don’t think it would be free even if it was) contains the following two examples. First, we have Brian Carey and Tom Lyons:

The difficulty is who will fund the establishment of Nama 2. Nama is current funded by the European Central Bank.

Then we have Damien Kiberd:

The Irish state has accepted responsibility for both sides of the several banks’ balance sheets. It has done this by providing guarantees that cannot, in extremis, be honoured and by purchasing distressed bank assets using money from the European Central Bank.

Unfortunately, this is not at all how the government, in the form of NAMA, purchased distressed bank assets. The reality is that NAMA purchased the assets by swapping them in exchange for Irish government-backed bonds. There – that’s how it was done. Not so hard to understand really. In fact’s it’s hard to misunderstand. NAMA is funded by you and me.

Of course, one can – if you want – discuss the idea that NAMA bonds can be repo’d with the ECB, if the mood is on them. (And indeed, from the last time we discussed this, I know there are people who comment on this site who have the ability to twist words in such a way that they can satisfy themselves that somehow saying “the ECB funds NAMA” makes sense – but frankly I think those folk are having a laugh.) But that doesn’t change the basic reality of the NAMA transactions.

Given the importance of NAMA as well as the important role the ECB is playing in propping up the Irish banking system, it is really unfortunate to see the roles played by these organisations being misrepresented in this fashion.

EU Commission Document on Bank Resolution Framework

The European Commission has released a “working document” that “seeks views on the technical details of a possible EU framework for the management of failing credit institutions and an appropriate class of investment firms.” There’s a press release here and an FAQ here.

The document contains a lot of sensible proposals that would lead to a common future European approach to dealing with failing banks, in contrast to the chaotic and disorganised approach that was seen during 2008-2009.

There’s plenty in the document worth discussing but, given the particular focus of this blog, it is clear that the most interesting aspect of the document is the annex starting on page 86 titled “Debt writedown as an additional resolution tool”.  It’s worth reading in whole but here’s the basic idea:

Thus, to provide additional flexibility and to ensure that any write down power is sufficient to deliver the policy objectives, this consultation outlines two possible models for additional write down powers. Building on the minimum powers above, the first ‘comprehensive’ approach aims to make a broad range of senior creditors face the real risk associated with bank failure. The second ‘targeted’ approach aims to create a more focused tool for resolving in particular, institutions which have been assessed as likely to prove difficult to resolve with traditional resolution tools at a time of fast moving idiosyncratic or systemic crisis.

Resolution authorities could be given a statutory power, exercisable when an institution meets the trigger conditions for entry into resolution, to write off all equity, and either write off subordinated debt or convert it into an equity claim. However, in some cases this will not be sufficient to ensure that an institution in difficulty returns to viability so as to maintain market and creditor confidence when the markets next open. (For example, RBS’ balance sheet at the end of 2007 contained £38bn in subordinated liabilities, while losses before tax in 2008 amd 2009 amounted to around £43bn.

As is de rigeur these days the Commission argues that “Such a power would only apply to new debt issued (or existing debt contracts renewed or rolled over) after entry into force of the power.”  In other words, existing European senior bank debt cannot take a haircut in this way.

However, the problem with this argument, as well its sovereign cousin (the idea that only post-2013 sovereign debt will be open to restructuring) is that it is subject to what economists call time inconsistency. As described by Wikipedia, “time inconsistency describes a situation where a decision-maker’s preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time.”

Today, Europe has lots of troubled banks and some troubled sovereigns. Ideally, the powers that  be would like financial markets to not worry about being defaulted on and to keep lending to these banks and sovereigns. No agreed EU resolution regime for banks or sovereigns is in place, so the authorities would like to reassure current lenders that they will be safe when such a regime is put in place and that it is future lenders who will take the hit.

However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.

The time-inconsistency of the current sovereign debt proposals are clearly recognised by sovereign bond markets, which are pricing current Irish and Greek government bonds at yields that clearly indicate the likelihood of default. For banks that are already in trouble, it seems unlikely that these proposals will really comfort bond investors that they are genuinely safe from getting haircut by a future resolution regime.

ECB Opinion on Credit Institutions (Stabilisation) Bill 2010

The ECB have issued a legal opinion on Credit Institutions (Stabilisation) Bill 2010 (documents here).  One highlight: “these emergency powers interfere significantly with the property rights of institutions’ shareholders and creditors. Thus it is important for any regime to properly balance these fundamental rights with the general interest in the financial system’s stability.”