Anglo’s Plan to Save Subordinated Debt Holders

It is now widely expected that the EU Commission will not approve Anglo’s Good Bank Bad Bank split and so there won’t be a good bank.

The media’s constant focus on whether the bank is being fully wound down or not has always been somewhat misplaced (I’ve been making this point for quite a while). Yes, the government would have to put extra money in to recapitalise the new bank but it wouldn’t be much (perhaps a billion or so) and, in theory, this investment could be earned back if the new bank was eventually sold off. In addition, the new bank would allow for the highest level of continuity for depositors and this could help restrict depositors leaving the bank which would complicate any adjustment to a new structure for Anglo.

In practice, there probably isn’t the basis there for a profitable new bank and there are other ways to deal with deposits, so I haven’t been a big fan of the split idea. However, this debate has been a distraction from the main issue affecting the cost of the bank to the Irish taxpayer, which is what the policy will be on the treatment of bondholders.

Now, however, a new reason has emerged to be against the new bank proposal. I had questioned here whether Anglo would have considered transferring subordinated debt liabilities to the New Bank. Now, Sunday Tribune journalist, Neil Callanan, informs us that Anglo’s management have informed him that their plan is to transfer some of the bank’s subordinated debt “to round out capital structure” (Thanks Neil.)

This is a bad idea on so many different levels. The idea about “rounding out the capital structure” sounds plausible but is, in fact, nonsense. International regulators have generally encouraged the issuance of subordinated debt because small numbers of professional bond investors may be better positioned to provide “market discipline” for the bank’s management than the shareholders, who tend to be poorly organized and easily deceived. The idea here is that the subdebt holders will lose all their money if the bank becomes insolvent, so they’ll pay close attention.

Now we have a bank which is insolvent and whose subdebt holders should get nothing. And the bank’s management wants to hive these bonds off into a new institution, fully capitalised at the expense of the Irish taxpayer, which would see the debt paid back in full.

One can only assume that Anglo’s management are aware that New Bank could “round out its capital structure” by issuing new subordinated debt, in return for which the state-owned bank would actually receive some money. But, for some reason, they would prefer to see the bank take on a legacy liability of Sean Fitzpatrick and co and pile it onto a new state-owned institution. The question is why they would want to do this.

The EU’s impending decision to prevent the new bank should stop all this. However, the planned subdebt transfer raises very serious questions about how exactly Mr. Aynsley and Mr. Dukes believe they are serving the Irish public with their plans for New Bank.

Renewable heat and the cost of capital

Today’s Independent reports that the government is preparing the ground for meeting the renewables target for home heating. Geothermal energy is to play a part in this. Treacy Hogan gets the numbers right, but does draw the obvious inference. Would anyone invest in a project with a payback period of 12-36 years? In a country that is desparately short of capital?

A friend of mine used to sell heat pumps. He had a brilliant marketing ploy: “The payback period is 40 years.” Most of his customers thought you need to maximise the payback period, so he sold loads.

As with most renewables, for geothermal energy, the fuel comes for free, but the capital does not. Compared to fossil fuels, the price risk is gone, but the interest rate risk is higher.

Exposures of Foreign Banks to Euro Periphery

The same BIS Quarterly Review also carries an analysis of the holdings of foreign banks (with a geographical breakdown) in the troubled periphery of the euro area and shows the allocation between claims on the public sector, banks and the non-bank private sector: you can read it here.

As has been pointed out repeatedly on this blog, the claims on Ireland have to be treated with some caution in view of the role played by IFSC-located entities. In its coverage of this new article, the New York Times highlights the probable role of Hypo Real Estate’s subsidiary in Dublin (the former Depfa bank) in contributing to the high claims of Germany on the Irish non-public sector.

Debt Reduction After Crises

The new issue of the BIS Quarterly Review carries some interesting empirical work on debt reduction after crises.  The paper is here and the summary is:

Financial crises tend to be followed by a protracted period of debt reduction in the nonfinancial private sector. We find that a period of debt reduction followed 17 out of 20 systemic banking crises that were preceded by surges in credit. Debt/GDP ratios fell by an average of 38 percentage points, returning to approximately the levels seen before the increase. If history is any guide, we should expect to see a much more significant reduction in private sector debt, particularly of households, than has so far taken place after the recent crisis. The costs of this process in forgone output are difficult to pin down, but there are reasons to believe that they need not be high provided that the banking sector problems that led to the crisis are fixed.

The Costs of Default

Panizza, Sturzenegger, and Zettelmeyer’s influential 2009 Journal of Economic Literature survey on the economics of debt and default has been referenced on different threads over the last few days.   The message has been that the costs of sovereign default in terms debt market access and borrowing costs are relatively low.   While I know that those referencing the paper know these findings provide only part of the picture, I am concerned that some blog readers will come away with too strong a conclusion. 

The puzzle of sovereign debt markets is that they should only be possible if there are costs to default – and especially to voluntary default.   In contrast to corporate borrowers, legal sanctions do not provide much of a deterrent for sovereign governments.   The traditional explanation has instead focused on the value of reputation and thus on future access.   But the finding of low direct capital market punishments for defaulters has put that explanation in doubt. 

Yet sovereign debt markets are alive and well.   From this we can infer that there must be costs of some sort.   Recent attention has focused on domestic costs, such as the costs of severe output losses that have accompanied a number of recent debt crises. 

Here is what Panizza et al. (cautiously) conclude:

If anything, defaults appear to be deterred by the domestic “collateral damage” that tends to accompany debt crises, rather than punishments from outside.   While it is very difficult to empirically disentangle the causes and effects of defaults, there is at least some evidence supporting the idea that defaults may magnify the output drops observed during debt crises.   Once output costs in line with this evidence are assumed in parameterized models of sovereign borrowing, the level of sovereign debt that can be sustained in equilibrium rise to more reasonable levels compared to models in capital market penalties are the only punishment. 

One interesting possibility is that in a world with uncertainty about government/country type, revealing yourself as “non-honest” can have implications for broader dealings both domestically and internationally. 

Even if we take a strict cost-benefit perspective, we should approach “default” cautiously – whether it is debt restructuring or the revocation of guarantees.