Following up on last week’s story about Anglo suspending interest payments on certain bonds, the Sunday Tribune had a nice article by Emmet Oliver that sheds some light on the issues surrounding this decision. Also in the Tribune, my old friend Jon Ihle reported the feel-good news story of the week about a certain bond investor who’s going to lose out as a result of this decision.
Thanks to Karl D. for the tip-off on this story. Anglo Irish has announced that it will not be paying coupons on its Tier 1 subordinated bonds and that this decision was required by “The European Commission, as a condition of its approval of the Government’s capitalisation of the Bank of up to €4bn.” In a related story, the International Swaps and Derivatives Association has decided that a similar non-payment by Bradford and Bingley represents a “credit event” which will trigger CDS insurance. (Bloomberg story here, official announcement here.)
Presumably, Anglo’s actions will at some point trigger the same decision from the ISDA. This will mean that those Anglo bondholders holding CDS insurance will receive full payment. Anglo’s announcement also discusses its “liability management” exercise, in which it is planning to buy back outstanding debt at below par. Presumably, however, those insured by CDS will no longer be interested in a deal of this sort. It also makes it likely that much of the debt that Anglo is planning to buy back at a discount will be owned by CDS issuers.
Update: My presumablys were perhaps a bit presumptious. Commenter Eoin notes below that this is not (yet) a credit event. I have checked this elsewhere and am informed that the “reference” obligation that defines a credit event for Anglo is indeed a failure to meet Tier 2 obligations.
A common pattern when an important economic story comes along is that the media and politicians decide quickly what the issue boils down to and then, even though they’ve got it wrong, this sets the tone for weeks. Recent examples of this phenomenon include the February\March “do we need a bad bank?” debate, which was followed by the equally specious “NAMA versus nationalisation” debate.
Over the last few days, the media and political debate about Anglo Irish Bank has largely focused on the question of whether the bank should be wound down or kept on as a going concern. Those who favour winding down the bank appear to view the funds the government has committed to re-capitalising Anglo as the cost of keeping the bank going and, on that basis, they argue strongly for the wind-down option as being cheaper for the taxpayer.
An example of this line of reasoning is an article in today’s Irish Independent (titled “Taxpayer getting bullied into saving Anglo Irish”) by new Fine Gael TD, George Lee. George puts the case for winding up the bank along these lines:
The problem, of course, is that the people associated with the bank, including the Government, are refusing to bury it … Instead of pumping billions into a failed bank that will never, ever again be profitable, it is much better to wind Anglo down.
I do not think that this is a useful way to characterise the decisions facing the government in relation to Anglo Irish Bank, for a few reasons.
From today’s Sunday Times:
Brian Lenihan, the finance minister, said last week that the plight of Anglo Irish Bank was a reminder that nationalisation carried a heavy price for taxpayers.
Lenihan held up Anglo as a warning to academic economists who support the nationalisation of Ireland’s big two banks, Bank of Ireland and Allied Irish Banks.
A direct quote along these lines is reported in Saturday’s Irish Times. The Minister is quoted as saying that
Anglo’s need for capital “illustrates the point that, when nationalising a bank, there is an issue for the taxpayer”.
Ok then, perhaps I shouldn’t bother taking the bait at this point, but let’s think about this for a second.
Suppose Anglo had remained in private hands after last Autumn, perhaps with new management after Seanie and co were cleaned out. Now they report losses that wipe out their capital base.
What would the government do at this point? No private investor would be willing to recapitalise Anglo. The government could decide to let Anglo be liquidated. However, the September 30 guarantee would then put the government on the hook for paying back Anglo’s liabilities and a disorderly asset firesale would probably only make things worse. (Which is the government’s argument for not winding up Anglo right now.)
So, because of the September 30 guarantee, the government would be forced to re-capitalise Anglo now, whether the bank had previously been nationalised or not. To blame the cost of re-capitalising Anglo on the decision to nationalise is putting the cart before the horse. The principle argument in favour of nationalising Anglo was that the government had guaranteed its liabilities and could not afford to keep a discredited management in place gambling with taxpayers money.
I would summarise the moral of the story here somewhat differently: When issuing blanket guarantees to troubled banks, there is an issue for the taxpayer.
Anglo Irish Bank has announced losses that bring its measured shareholders’ funds down to about 0.1 per cent of total assets — effectively zero. It has also announced a further €3.4 billion in expected loan losses, little of which would be offset by operating income over the next year or so.
From a strict contractual point of view, the next in line for absorbing these losses are the subordinated debt holders. There has already been some discussion on this site of the issues involved here.
Now we are at a crunch point because a recapitalization of Anglo cannot be long-delayed. Indeed, to continue trading, the bank presumably needed the assurance that was provided by the Government today that needed capital would be forthcoming.
There is €2.8 billion of unguaranteed sub-debt on Anglo’s books. I am assuming that part of the Strategic Plan promised by the bank this morning will have to involve risk-sharing by sub-debt holders. This could take the form of of a deeply-discounted buy-back (as indeed is already suggested in the Government’s statement). It could also take the form of a debt-equity swap. (This would parallel current discussions in the US around debt-equity swaps to recapitalize some of the larger US banks following their stress-tests).
Obviously none of this is easy, and these bondholders may want to play chicken. In a liquidation they would be wiped out, but — absent modern bank insolvency legislation here — a messy liquidation could also inflict severe taxpayer and economic costs.
I admit that I am not sure of the most effective way of accomplishing it. There are some obvious options. Perhaps readers will have some further ideas. I am sure that officials are pondering these issues.
But difficult does not mean impossible. The stakes here are evidently high.
Urgent work to modernize bank insolvency procedures (as recently enacted in the UK post Northern Rock) could strengthen the Government’s hand.
It might be argued that losses incurred even by sub-debt holders of a bank could damage the credit of the Irish government. I disagree.
First, it is really immaterial that the bank is Government-owned: eveyone knows that situation has only arisen as a result of the disastrous performance of the bank. No new subordinated debt has been issued since the nationalization. Besides, in his statement in the Dail on January 20, during the debate on the nationalization bill, the Minister removed any doubt about whether nationalization entailed an expansion of the guarantee.
More generally, even though there might be an immediate knee-jerk reaction in market prices of debt, mature reflection by the financial markets would recognize that a country honouring its debts and guarantees to the letter–and not beyond–was more creditworthy than one which handed over money lightly to unguaranteed risk investors.
Now that Anglo has officially blown through essentially all of its capital, and given that the government regularly cites PWC’s recent assessment of BOI and AIB’s likely capital needs, I thought it might be a good moment to remind folks of this excerpt from the PWC report on Anglo (released in February, fieldwork concluded on December 10):
Under the PwC highest stress scenario, Anglo’s core equity and tier 1 ratios are projected to exceed regulatory minima (Tier 1 – 4%) at 30 September 2010 after taking account of operating profits and stressed impairments … We used an independent firm of property valuers (Jones Lang LaSalle) to value a sample of 160 properties held as security in relation to the top 20 land & development exposures on Anglo’s books as identified in our Phase II review and report. The results of this work indicated that impairment charges over the period FY09 to FY11 would fall in a range between the two PwC impairment scenarios but closer PwC’s lower impairment scenario.
With Anglo about to report its results, last Sunday’s newspapers contained stories that the government was considering not honouring coupon payments on Anglo’s Tier 1 perpetual bonds. In light of that, it is interesting to note the following story (from Wednesday’s FT):
Bradford & Bingley, the nationalised mortgage bank, quietly issued three statements after the market had closed on Tuesday, informing holders of three classes of notes that they would not now be getting their next due interest payment.
The FT notes that the market value of these bonds collapsed on this news. Anglo’s perpetual bonds have been trading at about 15% of par value lately.
Update: Anglo results released here along with a statement from the Minister of Finance. The loss of €4.1 billion essentially equates to all of its equity capital (see page 23 of the report’s PDF file.) And from the Minister’s statement:
the Government has decided, subject to EU approval, to provide up to €4 billion of capital to Anglo. The bank is also in a position to generate further capital of its own by buying back certain outstanding subordinated loans from bondholders at a significant discount to par value. This exercise will generate profit and additional capital for the bank.
See page 50 of the report’s PDF file for details on Anglo’s subordinated debt, which has a book value of €4.9 billion. About €2.1 billion of these bonds are dated, and thus covered by the guarantee up to September of next year (though the earliest maturity is 2014). The remaining €2.8 billion are undated and are not covered by the guarantee.
Ashoka Mody of the IMF has written an interesting paper on European sovereign spreads: more details here.